For as long as I can remember I have been reading financial reports about the coming ‘hard landing’ in China – and explanations from the financial wizardry as to why there won’t be a hard landing as long as the Communist Party is in charge and in funds. Earlier this week it seemed that the wizardry had finally been proved wanting, with consecutive days of near 10% falls in the mainland and Hong Kong stock markets, and enough downs and ups in Western markets to make it seem as if the day of doom was close to hand. Is this the end of the China boom? Is it the beginning of the next recession? Could this be the final, violent phase of the global crash that began in 2007?
The meaning of financial convulsions is seldom clear close to the moment of turmoil. They are usually caused by imbalances in the global economy – ‘imbalance’ being the word that financial economists use to describe a temporary irrationality. It is clearly irrational to expect that the valuations of Chinese companies would keep rising at a time when exports are weak, when forward indicators of industrial production are falling, and when the overall rate of GDP growth is falling. Financial markets are often irrational in the short term, and sometimes for longer than that. It is impossible to know whether China’s markets have over-corrected, or hit a stable level, or will fall further. There are too many uncertainties: over what the Chinese authorities may do, over the mood of the market in China and beyond. But one thing is sure: China hasn’t crashed, yet.
For one thing the falls in prices in the Shanghai and Hong Kong stock markets have done nothing more than erase the gains of months. The Hong Kong index is down to around where it was in April 2014, and the Shanghai index is at its level of February this year. What is interesting about the trajectory of Chinese valuations is not so much the fall, but the rise: the Shanghai index more than doubled in the 12 months to mid-June this year, in a weakening economy. Every investor knows the mantra ‘markets are not economies’, but this was exceptional.
It is estimated that the Chinese government has spent anything up to $200 billion in keeping this stock-price boom going through this year. It has been part of the Beijing game plan to keep the market hot as a way of shifting corporate investment away from foreign sources and into the domestic economy, but it got out of hand. Most of the $200 billion was spent in trying to keep the bubble from bursting after prices turned in the second week of June. The reason that the markets fell out of bed at the beginning of this week is that investors realised that the Chinese government had finally given up on this strategy – ‘capitulated’ in the investment phrase – and were turning to devaluation as an alternative way of boosting the economy.
But stock markets and their gyrations are not in any case a very good way of gauging the underlying economy – they hint at what is happening, but as through a glass darkly. That is particularly true of China, where frequently only very small slices of the total value of companies are traded, and where prices fluctuate extremely on small volumes of share dealing. Behind the headline figures, the real Chinese economy may not correspond to what the stock market suggests. Alarmingly, it may be worse than it looks.
It is important to recall that China has just been through the biggest investment boom in history. Corporate investment has accounted for about 50% of Chinese GDP for several decades. The result has been the rapid development of the world’s biggest manufacturing sector, a rise in living standards and prosperity for very many in the world’s biggest country, and inevitably an overhang of massive over-investment in infrastructure and private enterprise. That might not matter so much if the world economy was growing fast enough to take up the capacity that China has over-built – but it is not. Recovery from the global meltdown of eight years ago has been weaker than even pessimists expected, with only the US and the UK standing out as strong-growth developed economies.
A sudden slowdown that turns into a protracted recession is what happens after an investment boom that runs too hot for too long. It happened to Japan at the end of the 1980s in circumstances that are in some ways comparable to China. This is one reason that markets outside China get very easily spooked by the way that a whole range of Chinese indicators – stock markets, production, employment – are pointing sharply downwards. Luckily, there is an upside. China today has a lot more scope than Japan had a quarter century ago to move its economy upmarket to more profitable territory, a journey it has already begun.
But that is for the long term. For now, China is reminding financial investors that the days of pedal-to-the-metal growth in emerging markets are over. The investment capital that has poured into China and other emerging markets – not least thanks to quantitative easing, which created a vast ocean of developed world money looking for developing world returns – is now being withdrawn where possible. Some of it may have to be written off. Private corporate borrowers in emerging markets have increased their indebtedness massively over the last few years, and particularly so in the case of China and Hong Kong taken together. The conditions for a private sector debt crisis in emerging markets, including China, are in place. Investors know that economies with weakening currencies and foreign exchange borrowing are not a good place to be.
So the state of play is this. China has had a meltdown, but with the mainland stock market still 50% higher than it was in June last year a rational market should see further falls, because the economy is in worse shape than 14 months ago. China has devalued, but will probably have to do more to make much of an impact on growth. Lenders to China and other emerging markets will probably soon be heard explaining away some more unexpected losses. The overall temperature of the world economy has probably dropped a fraction. It might get no worse than that.
But what happened this week – that wasn’t the crash.